S&P’s Dilemma: Rating your Regulator

In a court filing today, the rating agency Standard & Poor’s (S&P) claims
that the federal case against them is motivated by retaliation for its
2011 decision to strip the United States of its “AAA” credit rating.

It might be easy to dismiss this claim, but they aren’t the only ones
in this situation. Before S&P’s U.S. downgrade, the smaller firm
Egan-Jones, which relies on a subscriber model also downgraded the
United States. Not long after, Egan-Jones was investigated by
the SEC and ultimately barred for a time from rating U.S. debt. Let’s
remember that Egan-Jones was ahead of the curve in spotting both the
subprime bubble and the failures of WorldCom and Enron.

If you didn’t downgrade the United States, what happened? Basically
nothing. We see what starts to look like a pattern here: downgrade the
United States and expect some abuse. Don’t and you will be largely left
alone. And as the recent IRS treatment of Tea Party groups has shown:
this administration isn’t above targeting its enemies.

There are, as expected, several twisted ironies to the case. First,
the Department of Justice is claiming to act on behalf of banks that
suffered losses from holding rated securities. But who was it that
imbedded ratings into the bank regulatory process? The bank regulators.
If the DOJ wants to punish someone for bank losses on rated securities
it should start with the Basel Committee. And then there’s the DOJ
itself, which uses a flawed theory of disparate impact to pressure banks
to make bad loans in the first place. The DOJ doesn’t have to go far to
find the guilty: just try looking in a mirror.

The solution here is ultimately to get the federal government out of
regulating the rating agencies. Our entire financial system is built on
sovereign debt. The crisis in Europe shows what happens when you get the
treatment of sovereign debt wrong (for a good summary of sovereign risk
in bank regulation, see this BIS speech).
The conflicts of interest between raters and regulators are ultimately a
far greater threat to our system than any conflict between corporate
issuers and raters.